Liquidity Preference and Portfolio Theory: A Comparative Analysis

1. The General Theory and Victoria Chick at 80 A Celebration in collaboration with The Post-Keynesian Economics Study Group and the Association for Heterodox Economics Gustave Tuck Lecture Theatre1, University College London Monday 11 July 2016 Weight of argument and liquidity preference: Maynard Keynes and Victoria Chick Alessandro Vercelli Department of Political Economy and Statistics University of Siena

2. The emergence of liquidity preference theory According to Hicks the concept of liquidity first appeared in the Treatise on Money (Hicks, 1989, p.61, and 1962, pp. 238-47) we may find predecessors but only with Keynes liquidity enters in economics as crucial theoretical construct deeply affecting economic theory and policy: liquidity preference theory as cornerstone of Keynes’ theory This may be explained in historical terms: Keynes wrote when the process of financialisation had conferred to liquidity a prominent role. In particular: • the Great Depression had made evident the crucial role of liquidity in affecting the financial stability of the system • the quantity and variety of securities had greatly increased, giving a crucial role to liquidity in designing portfolios and in orientating investment

3. Liquidity preference vs portfolio theory Also portfolio theory emerged in the same period (Makower and Marshak 1938) Victoria Chick rightly emphasised the deep difference between Keynes and standard portfolio approach: “The portfolio approach is usually seen as a development of Keynes’s model. I see it as fundamentally opposed. The crucial departure of the portfolio approach, away from Keynes, is the aggregation to a spectrum of assets, rather than to a group of transactors … Consumers, firms, the banking system, other intermediaries, and the stock market have disappeared, as they did in ISLM analysis” (1977 p.98) This disappearance is not by chance: “ … it is easier to assume away distribution among “economic units” or “transactors” than among recognizable social groups” (ibid n.2) “The whole need for stabilization policy stems from the divergence of the plans of households and firms … In the portfolio approach, in fact, government intervention is always a cause, not a cure, of disequilibrium” (ibid p.102)

4. Liquidity preference and Chap 17 of the GT However, in an intermediate stage of the analysis, it is useful to study the determinants of the choices of the composition of (individual or aggregate) portfolios as Keynes did in Chap. 17 of the GT. This is important to understand the role of liquidity preference in the economy. Following approach and notation of Chap. 17 of the GT, the return Rof any asset is given by: R = q - c + a + l q indicates the asset’s expected return net of risk premium (the risk of incurring in a loss to convert an asset in cash in case of unforeseen contingencies) c indicates the expected costs of keeping the activity a indicates the expected appreciation (or depreciation) l indicates the liquidity premium In this view, the value of liquidity is a crucial component of the value of an asset and thus a crucial determinant of individual and aggregate portfolios

5. Two crucial dichotomies We can distinguish the main components of liquidity preference by crossing two dichotomies: weak 1) } uncertainty strong uncertainty aversion 2) { potential learning

6. Modalities of uncertainty and weight of argument From the definition of weight of argument (Vercelli, 2010): V(x/h) = K / (K + I) where the weight of argument V (x/h) depends on the ratio between available relevant knowledge K and complete knowledge (including relevant ignorance I) we may defines different modalities of uncertainty in a rigorous way: V(x/h)= 1 weak uncertainty 0 < V(x/h) < 1 strong uncertainty V(x/h) = 0 radical uncertainty In principle, the behaviour of decision makers changes under different modalities of uncertainty: they adopt different decision rules (EU, maximin, mix of the two)

7. Uncertainty aversion and potential learning risk (weak uncertainty) Uncertainty aversion { (strong) uncertainty psychological attitudes that are a precondition of the agent’s rationality as it reflects awareness of ignorance: awareness of ignorance → learning → rationality mere updating of the information set Learning { genuine learning that increases the weight of argument Awareness of ignorance and genuine learning disregarded by mainstream economics → paradoxes of substantive rationality (e.g. Grossman and Stiglitz, 1980)

8. Synoptic table Table 1: The main components of liquidity preference

9. A: Liquidity Preference as Behaviour towards Risk This aspect of liquidity was the first to be formalised (Modigliani 1944, and Tobin 1958) the focus on weak uncertainty was consistent with the remarkable financial and economic stability of the Bretton Woods period (1944-1971) The limits of this approach have been clearly emphasised by Victoria Chick: the assumption of weak uncertainty neglects the more important “behaviour towards uncertainty”, i.e. strong uncertainty (Chick, 1983, pp. 214-16) In particular, the impossibility of giving a role to learning makes Tobin’s theory unable to explain the speculative demand of liquidity

10. B: Liquidity preference as intertemporal option value This aspect of liquidity value has been formalised by Hicks (1974), Arrow and Fisher (1974), Henry (1974a and b), Makowsky (1989) In an intertemporal decision problem characterised by weak uncertainty, irreversibility and opportunity of learning, a more liquid position has an intertemporal option value that is an increasing function of liquidity and potential learning This view was consistent with a more turbulent era characterised by the need to adapt promptly to new circumstances through learning

11. C: Precautionary motive According to Keynes the value of liquidity does not depend on complex comparative calculations of future assets returns made possible by weak uncertainty but on the degree of confidence on these calculations The increasing financial instability contributed to attract a growing attention to strong uncertainty vindicating Keynes’ insights on C and D As for C, Keynes stresses the importance of strong uncertainty for both demand motives: Keynes maintains that 'a large increase in the quantity of money may cause so much uncertainty about the future that liquidity-preference due to the precautionary-motive may be strengthened’ (Keynes, 1936, p.172) The view C has been emphasised by Runde (1994) and Winslow (1995)

12. D: Speculative motive Victoria Chick stressed the link between strong uncertainty and speculative demand (Chick, 1983) The paradigmatic example in Keynes is that of a bear speculator who keeps liquidity in his portfolio to be ready to exploit the opportunities offered by an expected increase in the rate of interest this is nothing but a special case of a general conceptual structure: a more liquid portfolio allows a more efficient exploitation of future information The view D has been formalised by Jones and Ostroy (1984) who have utilised a multiple-prior approach and, more recently, by Dow and Werlang (1992a and b) who have utilised an approach based upon Choquet capacity theory

13. On the Keynes’ view As Victoria Chick maintained, the emphasis of Keynes is mainly on components C and D Keynes and Chick rightly played down the components A and B since they have a very limited scope: • weak uncertainty theories are based on the independence axiom that guarantees the intertemporal coherence of tastes and beliefs: this leaves a limited scope, if any, for genuine learning that implies a change in tastes and beliefs (ii) the value of potential learning under weak uncertainty is zero since each variable is represented by a unique, fully reliable, additive probability distribution

14. Keynes and Chick vindicated Strong uncertainty plays a crucial role in the explanation of the empirical evidence on liquidity preference. This is admitted also by recent econometric literature. Early examples are: • the high volatility of securities prices, puzzling under the assumption of weak uncertainty, receives a simple explanation under strong uncertainty (Dow and Werlang, 1992a) ii) the price inertia in financial markets is explained as the consequence of rational behaviour under strong uncertainty without being compelled to introduce ad hoc assumptions on the elasticity of prices (see in particular Simonsen and Werlang, 1991) iv) an increment of uncertainty increases the investors’ inertia explaining the so-called “liquidity trap” without ad hoc assumptions on the elasticity of liquidity preference curve (Dow and Werlang, 1992b)

15. Concluding remarks:Weight of argument and liquidity preference Chick’s interpretation of liquidity preference theory is fully supported by a thorough understanding of the crucial role played by the concept of weight of argument: not only because it coordinates the different components and their value, but also because it may explain how the evolution of the economy and its fluctuations alter the value, and relative weight, of each of the four components • in a period of financial tranquillity, the weight of argument is high so that A and B may have some significance, making the mainstream view of liquidity preference less inadequate • in a period of crisis, the weight of argument is low so that C and D further increase their preeminence • in a deep crisis, the weight of argument is so low that C and D lead to a persistent liquidity trap This is the current situation

16. Thank you for the attention!

17. References Chick, V. 1977. The Theory of Monetary Policy. Revised edition. Oxford: Basil Blackwell. Chick, V. 1983. Macroeconomics after Keynes A reconsideration of the General Theory. Oxford: Philip Allan. Chick, V. 1991. “Hicks and Keynes on Liquidity Preference Theory. A Methodological Approach.” Discussion Paper 91-11, Dept. of Economics. University College, London. Vercelli, A. 1996. ‘‘La teoria della preferenza per la liquidità: opzioni interpretative e valori d’opzione’’. In C. Gnesutta, ed., 1996, Incertezza, Moneta, Aspettative, Equilibrio. Saggi per Fausto Vicarelli, Bologna, Il Mulino, pp.141-167. Vercelli, A. 2010. “Weight of argument and economic decisions”. In S. Marzetti and R. Scazzieri, eds., Fundamental Uncertainty, Rationality and Plausible Reasoning, Palgrave Macmillan, pp.151-170.